How Monetary Policy Affects Markets
Monetary policy is applied by the country's central bank to regulate money in the economy.
The main purpose of monetary policy is to stabilize the economy. However, it can vary from country to country. For instance, in the U.S., the goal of monetary policy is to maintain balanced prices, interest rates and to promote employment.
To discuss its impact on the markets, it's important to mention types of monetary policies.
1. Contractionary and Restrictive
In this type of monetary policy, a country cuts the money supply and increases interest rates. This slows economic progress. The borrowing of money becomes difficult, and it reduces consumers' and businesses' spending. It is also called tighter monetary policy.
2. Expansionary or accommodative
Also known as the loose monetary policy, it is the opposite of contractionary and restrictive policy. It increases the supply of money and decreases the interest rates.
Neutral monetary policy doesn't contain or expand the money supply, hence not creating economic growth.
Just like traders analyze the market to take their positions, central banks make decisions regarding the overall economy.
Effects on the markets
In an expansionary monetary policy:
- Logically, if the country's monetary policy is expansionary or accommodative, its currency will depreciate against others. However, it depends on monetary stimulus and overall economic growth. For instance, in 2013, the USD became stronger even though there was an accommodative policy. The greenback rallied because of a boom in the employment and housing sector, which increased global demand for USD.
- Commodities are considered risky assets, and they tend to appreciate in an accommodative policy. There are various reasons for this. Lower interest rates increase investors' risk appetite. Physical demand for commodities also surges due to the growing economy.
- The stock market typically is in a bullish zone during a period of expansionary policy. People invest in the stock market due to easy money borrowing combined with low-interest rates. The companies offering equities can also buy more money to invest in new ventures, thereby increasing its stock value.
In an expansionary monetary policy:
- If there is a high-interest rate, the national currency appreciates against its counterparts. For example, between 2010 and 2012, the USD/CAD remained bearish because of the tight monetary policy by the Bank of Canada. In 2013, when BOC decided to adopt an accommodative monetary policy, the CAD fell against the USD.
- The stock market tends to underperform during periods of restrictive monetary policy. Due to higher interest rates, investors tend to stay away from buying risky assets.
- The commodities market performs in a similar manner to the stock market. It's interesting to know that in the initial phase of restrictive monetary policy, commodities spike up and then take a dip in the later phases, as higher interest rates slow the economy.
It does not matter whether it is accommodative or restrictive; monetary policy changes can have a significant effect on the financial market. Therefore, traders need to keep track of monetary policies so they can invest accordingly.
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The vast majority of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.